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Manufacturing gloom

The UK economy is not on the brink of recession although the manufacturing sector has been hit hard....

The UK economy is not on the brink of recession although the manufacturing sector has been hit hard.

Manufacturing output for the three months to June fell by 2% and by 1.3% year on year, rendering a fall in output for the second successive quarter. With the painful outbreak of foot and mouth aggravating matters, it came to no-one's surprise that the sector is in recession.

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Jamie Lewin, global market economist at Gartmore, says: 'I think to say that manufacturing is in recession is a fair reflection of the sector. It has been experiencing difficult conditions for a while but this is not confined to the global slowdown. Rather, it started with the strength of the pound. The slowdown deteriorated the situation because the sector was hit on two fronts.'

Manufacturing accounts for only 20% of Britain's economy, so there is no apparent danger of a snowball effect on the whole economy. Moreover, the services sector is holding up well and the UK is expected to come out with a growth of 1.5% this year despite the strains in some sectors.

'There is a risk that other sectors might follow the manufacturing one with rising unemployment levels,' says Lewin. 'However, consumer spending and wages are still showing upbeat figures. Consequently, the service industry is sufficiently strong to ensure that the UK economy does not fall into recession.'

Nevertheless, the Bank of England's (BoE) report on the UK economy predicts some gloomy times ahead. So far the housing market and consumer demand have been strong. However, there is anticipation of dampening sentiments with companies announcing redundancies and disappointing profit margins, which is attenuating the strength of the domestic economy.

Robin Woodall, director of UK equities at Foreign and Colonial, points out that the BoE's forecast might be too gloomy. 'The BoE focuses on the domestic economy while large companies like HSBC, BP and Shell make their profits overseas,' he insists. 'Once these markets pick up, the prospect might be better. From the equity market's point of view, the BoE's report is a little too gloomy.'

Overall there is optimism that rate cuts, both in the US and the UK, would help the UK economy pull through. While the economy is facing tough times ahead, the recovery is thought to be U-shaped and will drag on for some time before the economy can be restored to a more stable state.

Woodall points out: 'We are foreseeing slower economic growth for this year. However, interest rate cuts will bring the economy back from the gloom but it is much likely to be a quick slowdown and a slow recovery situation.'

fund manager comment: Aberdeen Asset

Corporate earnings growth is clearly under pressure as the economy slows. Profit warnings are likely to continue apace, but overall results remain broadly in line with expectations at the aggregate level. The level of growth overall for 2001 is still forecast to be reasonable by international comparison, particularly given the modest nominal GDP backdrop.

UK equities look extremely attractive vs gilts, with the gilt/equity earnings yield ratio at the bottom end of its 20-year range. Meanwhile, the UK remains relatively attractive from an international perspective. Corporate news flow is likely to get worse before it can get better, particularly where there is exposure to the capex cycle. Buy much of this should now be discounted, particularly outside the defensives. The technical backdrop remains supportive with institutional liquidity at historically high levels, continued equity retiral (via buybacks and special dividends) and further merger and acquisitions activity is likely, including cash bids.

While the defensive/value rally looks extraordinarily mature, economic uncertainty continues to squeeze these stocks and sectors to relatively extreme levels, even though earnings in many cases are being downgraded. Meanwhile, growth stocks have been continually marked lower and multiples compressed. Since decent organic top-line growth remains a struggle to achieve and genuine growth themes are relatively rare, premiums are likely to be restored and expand once again, provided the anticipated US downturn is not worse than currently discounted.

Overall, the FTSE 100 Index is now down 5% over three years. Last year's drop was the largest for a decade. The market has not fallen in consecutive years since 1973/74. Confidence remains crucial and is currently almost totally absent. Nevertheless, falling interest rates are usually extremely supportive of equity markets.